What Credit Cards Cost the Poor

By Daniel Indiviglio

It's fairly well-known that less affluent people have trouble getting credit cards, and when they do they often are forced to pay higher interest rates. But a new study shows that, even if people don't use credit cards, the payment method's mere existence makes them poorer. This is an unfortunate feature of the credit card industry, but unfortunately, there's no escaping it without reducing overall card usage.

The study (.pdf) was completed by the Federal Reserve Bank of Boston. It's pretty long and technical, but here's the abstract, which is really most of what you need to know:

Merchant fees and reward programs generate an implicit monetary transfer to credit card users from non-card (or "cash") users because merchants generally do not set differential prices for card users to recoup the costs of fees and rewards. On average, each cash-using household pays $151 to card-using households and each card-using household receives $1,482 from cash users every year. Because credit card spending and rewards are positively correlated with household income, the payment instrument transfer also induces a regressive transfer from low-income to high-income households in general. On average, and after accounting for rewards paid to households by banks, the lowest-income household ($20,000 or less annually) pays $23 and the highest-income household ($150,000 or more annually) receives $756 every year. We build and calibrate a model of consumer payment choice to compute the effects of merchant fees and card rewards on consumer welfare. Reducing merchant fees and card rewards would likely increase consumer welfare.

First, let's consider these findings, because they're significant. The existence of credit cards in the market involves a monetary transfer from those who don't use them to those who do. Cash-users lose an average of $151 per year to subsidize card users. The latter group gains an average of $1,482 each year thanks to the benefits of being a cardholder. Since the rich use credit cards more than the poor, this translates to a strange wealth redistribution from the latter group to the former.

To be sure, this situation is undesirable. It's frustrating to imagine that you're making the poor worse-off each time you swipe your credit card, but how can we correct this injustice? The paper offers a few ideas. A few of the more substantial ones include lowering merchant fees, differential pricing, and additional wealth redistribution. By considering each separately you'll see that they all result in a similar, undesirable outcome.

Lower Merchant Fees

First, it may help to explain what these merchant fees are, so that there's no confusion. Stores pay some percentage of each credit transaction to card companies. For example, if you purchase something for $100, the shop might have to pay the company 3%, or $3, when you swipe your card. So if the store paid $80 for that product, this fee drops its profit from $20 to $17.

But since merchants don't generally have different prices for using cash or cards, anyone who uses cash pays this premium targeting cardholders as well. So if you lower these fees, then the cash users, and broadly the poor, will face a smaller premium and will be better off. In fact, a provision in the Dodd-Frank financial regulation bill required these fees be lowered for debit transactions.

Unfortunately, banks and finance companies will have to make up that lost revenue somewhere else, either through additional fees or with higher interest rates on cards. If you hike up the fees, then fewer people will use credit cards, because they won't find the convenience worth the cost. Higher interest rates, on the other hand, likely harm poorer consumers, since wealthier people are generally convenience users and don't need to run a balance. So the primary effect would be less credit card use, with higher cost for poor users a secondary outcome.

Differential Pricing

Another option is to encourage stores to charge different prices depending on if customers use cash or cards. Let's go back to the example above. Imagine you're that person purchasing something with a price of $100 if you use your credit card or $97 if you use cash. Unless you're getting more than $3 in rewards on that transaction, you probably wouldn't use a card if you could use cash instead. The convenience of electronic transactions probably isn't worth 3% to most consumers. Again, credit card usage would necessarily decline among convenience users. But those who don't have the cash, but need to make a purchase -- likely poorer people -- would still be forced to pay the premium. So again, the primary and secondary effects seen above persist.

Wealth Redistribution

It's a little unclear precisely how this would work. But in its simplest conception, it could mean a more progressive tax scheme. Yet, if you asked relatively wealthy people if they would rather their income be taxed at a higher rate or switch from credit to cash, it's hard to imagine that many would some of give up much of their income to use credit cards. Another alternative might be a credit card usage tax, which is redistributed to the poor. Of course, this would discourage credit card use as well.

In all of these scenarios, credit card usage will almost certainly decline, and in a few poorer credit card users could be even worse off. Electronic transactions, however, are a positive innovation for commerce. Credit is good for a number of reasons. For example, credit cards make purchasing quicker and more efficient. They also make budgeting easier for consumers and businesses. Ultimately, the question comes down to whether the cost of placing an additional burden on the poor is worth the economic benefit that robust credit card usage provides. Unfortunately, due to the nature of the industry, it's not clear that there's a way to have both. In order to encourage more credit card use, the poor end up stuck with the bill.